Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $30 million in invested capital, has $4.5 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 12% interest on its debt, whereas LL has a 40% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure.
Calculate the return on invested capital (ROIC) for each firm.
Round your answers to two decimal places.
ROIC for firm LL is ________ %
ROIC for firm HL is ________ %
Calculate the rate of return on equity (ROE) for each firm.
Round your answers to two decimal places.
ROE for firm LL is ________ %
ROE for firm HL is ________ %
Observing that HL has a higher ROE, LL's treasurer is thinking
of raising the debt-to-capital ratio from 40% to 60%, even though
that would increase LL's interest rate on all debt to 15%.
Calculate the new ROE for LL. Round your answer to two decimal
places.
________ %
Answer a.
Firm LL:
Invested Capital = $30,000,000
EBIT = $4,500,000
Tax Rate = 40%
ROIC = EBIT * (1 - tax)/ Invested Capital
ROIC = $4,500,000 * (1 - 0.40) / $30,000,000
ROIC = 9%
Firm HL:
Invested Capital = $30,000,000
EBIT = $4,500,000
Tax Rate = 40%
ROIC = EBIT * (1 - tax)/ Invested Capital
ROIC = $4,500,000 * (1 - 0.40) / $30,000,000
ROIC = 9%
Answer b.
Firm LL:
Invested Capital = $30,000,000
Debt = 40% * $30,000,000
Debt = $12,000,000
Interest Expense = 9% * $12,000,000
Interest Expense = $1,080,000
Equity = 60% * $30,000,000
Equity = $18,000,000
Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($4,500,000 - $1,080,000) * (1 - 0.40)
Net Income = $2,052,000
ROE = Net Income / Equity
ROE = $2,052,000 / $18,000,000
ROE = 11.4%
Firm HL:
Invested Capital = $30,000,000
Debt = 60% * $30,000,000
Debt = $18,000,000
Interest Expense = 12% * $18,000,000
Interest Expense = $2,160,000
Equity = 40% * $30,000,000
Equity = $12,000,000
Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($4,500,000 - $2,160,000) * (1 - 0.40)
Net Income = $1,404,000
ROE = Net Income / Equity
ROE = $1,404,000 / $12,000,000
ROE = 11.7%
Answer c.
Firm LL:
Invested Capital = $30,000,000
Debt = 60% * $30,000,000
Debt = $18,000,000
Interest Expense = 15% * $18,000,000
Interest Expense = $2,700,000
Equity = 40% * $30,000,000
Equity = $12,000,000
Net Income = (EBIT - Interest Expense) * (1 - tax)
Net Income = ($4,500,000 - $2,700,000) * (1 - 0.40)
Net Income = $1,080,000
ROE = Net Income / Equity
ROE = $1,080,000 / $12,000,000
ROE = 9.00%
Firms HL and LL are identical except for their leverage ratios and the interest rates they...
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